Saving China's economy could imperil its banking system

Which sectors will benefit most from central bank's share market rescue plans? Ex securities chief calls for greater opening of Chinese financial sector.

Our briefing on key economic and financial developments in China as of Tuesday, 5 November, 2024:

• China’s banking system could come under pressure due to interest rate cuts intended to boost lacklustre aggregate demand.

• Pi Haizhou looks at which stocks will benefit most from the Chinese central bank’s new lending facility to boost the capital market.

• Ex head of China’s securities regulator says greater opening of the financial sector still needed to spur reforms.

China saving its economy via rate cuts puts the banking system in peril

The recent launch of cuts to interest rates by the Chinese central bank could weaken the country's all-important commercial banking system, by narrowing net interest margins and undermining profitability.

China recently saw its benchmark loan prime rates (LPRs) for October fall 25 basis points, to 3.10% for the one-year LPR and 3.60% for the five-year LPR.

The declines arrived in the wake vigorous credit and monetary loosening measures launched by the People's Bank of China (PBOC) - being the Chinese central bank - at the end of September, in a bid to boost flagging economic growth.

An expert from one of China's top economic think tanks points out that while the cuts will help boost the Chinese economy by shoring up demand, they could also put the banking system in potential peril.

Zhang Bin (张斌) from the China Finance 40 Forum points out that central bank rate cuts in China have traditionally had the opposite effect compared to advanced economies, serving to undermine bank profitability.

“The experience of advanced economies shows that central bank cuts to policy rates do not narrow interest margins, and commercial bank profits do not worsen," Zhang writes.

"When their central banks use interest rates cuts to increase demand levels, commercial bank profits rise as a consequence."

For almost a decade, however, interest rates cuts in China have produced the opposite effect.

"In 2015, when China made a large-scale reduction to policy rates, the fall in lending rates was much greater than the fall in deposit rates, and the interest margins of commercial banks narrowed by 60 basis points."

Any narrowing of the net interest margins of commercial banks diminishes their profitability, by reducing the difference between what they earn on interest from loans, and what they pay on interest for the liabilities that fund this lending.

Zhang Bin nonetheless considers central bank rate cuts to be a necessary macro-economic measure for boosting the health of the Chinese economy, by shoring up lacklustre aggregate demand.

"Interest margin risk should not become an inhibiting factor for adjustments to policy rates," Zhang writes.

"When it is necessary to increase aggregate demand and reductions to policy rates become needed, resolute action should be taken."

Given the adverse impacts on bank profitability however, he calls for the Chinese central bank "pay attention to those financial institutions with problems and adopt the necessary risk prevention measures."

Pi Haizhou looks at which Chinese stocks are set to benefit from the central bank's new capital market rescue measures

The People's Bank of China (PBOC) - being the Chinese central bank - recently launched a new lending facility to shore up the health of the country's stock market.

The facility supports lending by Chinese commercial banks for either share buy-backs by listed A-share companies or share increases by existing major share holders.

Prominent Chinese financial commentator Pi Haizhou (皮海洲) expects the move to provide especially strong support to several types of Chinese corporations, chief amongst them:

1. High-quality blue chip stocks with robust dividends. Given that the interest rate on PBOC’s "share increase loans" (增持贷) is only 2.25%, listed companies only need to provide dividends in excess of this amount for large-scale shareholders to have sufficient profit motivation to make use of the facility.

2. Companies whose larger shareholders are state-owned investors. Pi expects these state-owned investors to be subject to greater motivation to increase shareholdings to stabilise share prices.

3. Companies whose larger shareholders do not hold high equity percentages. Pi points out that where large shareholders hold high equity stakes in certain companies, they may be already approaching the "red line" of 75% equity which will limit further share purchases. "Only large shareholders with equity ratios that are lower will be more inclined to increase their shares, based on the desire to control enterprise holdings."

4. Companies whose share prices or share valuations are currently low. "When increasing shareholdings, large shareholders will give consideration to costs, as the higher the cost the greater the risk borne by large shareholders,” Pi writes. “It's precisely for this reason that when the share market is in the doldrums, share increase loans are most welcomed by large shareholders."

China can't reform its financial sector without external opening and cooperation: former securities chief

The former head of the China Securities Regulatory Commission (CSRC) has stressed the importance of China further opening up its financial sector in order to advance urgently needed reforms.

"Financial reform and development is impossible without financial opening and cooperation," said Shang Fulin (尚福林) at the Global Wealth Management Forum in Shanghai on 27 October.

Shang highlighted several reasons for why greater openness of the Chinese financial sector is especially imperative at the country's current economic juncture, including:

1. Emerging market nations are currently becoming the key engines of global economic growth.

2. Global trade growth is being negatively affected by geopolitical tensions and trade protectionism.

3. Technological innovations are reshaping international competition.